Mortgages with some of the characteristics of nontraditional mortgage products have been available for many years; however, they have historically been offered to higher-income borrowers. More recently, they have been offered to a wider spectrum of consumers, including subprime borrowers, who may be less suited for these types of mortgages and may not fully recognize the embedded risks. These borrowers are more likely to experience an unmanageable payment shock during the life of the loan, meaning that they may be more likely to default on the loan. Further, nontraditional mortgage loans are becoming more prevalent in the subprime market at the same time risk tolerances in the capital markets have increased. Banks need to be prepared for the resulting impact on liquidity and pricing if and when risk spreads return to more "normal" levels and competition in the mortgage banking industry intensifies.

The housing market has had an amazing run in recent years...You won’t hear me use the B-word to describe this remarkable activity. Instead, I believe fundamental factors can fully explain the expansion we’ve seen in the demand for housing, particularly rising incomes, rising population, favorable tax treatment, and very low interest rates. At the present time, mortgage interest rates are not as favorable as they were a few years ago, and so it is not surprising that we are seeing some signs of a tapering off of residential activity in many markets. For example, there were 1.28 million new single-family home sales last year, but so far this year the sales rate has averaged 1.14 million. I see this not as a precipitous decline, but rather as a return to more normal conditions in many markets...Looking ahead, it seems reasonable to expect the housing market to remain strong, even as some further tapering off in sales and production takes place.  The key point I would like to emphasize is that the housing phenomenon was not a mysterious, independent boost to the economy, driven by some sort of animal spirits, but instead was a rational response by households to the economic fundamentals, especially very low real interest rates. 

Unlike other mortgages, payments on [interest-only mortgages] increase when the interest-only term expires and borrowers are required to make principal as well as interest payments. These mortgages pack a double whammy when rates reset after the IO period expires. Many of these mortgages, however, have long periods during which the interest rate and IO period are locked up. Given that the average mortgage is held only six or seven years, many houses will be sold or refinanced before the amortization period ever kicks in.

Affordability products pose special risks--for instance, there is a greater likelihood that borrowers will experience negative amortization, that is, since the monthly payments do not cover current accruing interest, their mortgage balances will increase over time...When affordability products are offered along with easing of traditional credit underwriting practices, such as income verification and sound property appraisals, these products may pose potentially higher risks of default than traditional mortgages.

The apparent froth in housing markets may have spilled over into mortgage markets. The dramatic increase in the prevalence of interest-only loans, as well as the introduction of other, more-exotic forms of adjustable-rate mortgages, are developments that bear close scrutiny. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is adding to the pressures in the marketplace.

It is encouraging to find that, despite the rapid growth of mortgage debt, only a small fraction of households across the country have loan-to-value ratios greater than 90 percent. Thus, the vast majority of homeowners have a sizable equity cushion with which to absorb a potential decline in house prices. In addition, the LTVs for recent homebuyers appear to be lower in those states that have experienced the most explosive run-up in house prices and that, conceivably, could be at risk for the largest price reversal.

It has been suggested that borrowers, emboldened by rising house prices, are turning to nontraditional mortgages to qualify for increasingly expensive homes, setting the stage for potential repayment problems in the future. In this regard, the Federal Reserve surveyed banks on the importance of nontraditional mortgage products, such as loans with multiple payment options and interest-only mortgages. About 70 percent of those surveyed reported that such innovative products constituted less than 15 percent of the mortgages on their books. Interestingly, more than half the banks indicated that they were about as likely, or somewhat more likely, to securitize these products than traditional mortgage products. It would appear that whatever new risks may be associated with the increasing use of nontraditional mortgages are being dispersed across financial institutions and investors.

Speculative activity was also a part of the loan-officer survey [conducted by the Federal Reserve]. Over the past 12 months, more than three-fourths of the banks said that less than 10 percent of residential mortgage loans they originated went to the purchase of a second home or investment properties. At the same time, delinquency rates provide little reason for concern...Even so, we should not be overly sanguine about the housing boom and associated trends in home-mortgage lending...We will continue to keep a watchful eye for the potential dangers of stagnant or falling home prices in the future, combined with the potential for increases in mortgage payments relative to income.  

Industry experts are increasingly concerned about the quality of collateral valuations relied upon in home equity lending and residential refinancing activities.

[Federal banking agencies] have observed some easing of underwriting standards...Lenders are sometimes offering interest-only loans and are sometimes requiring very small down payments and limited documentation of a borrower's assets and income. They are also relying more on automated-valuation models and entering into more transactions with loan brokers and other third parties. Given this easing of standards, there is concern that portions of banks' home equity loan portfolios may be vulnerable to a rise in interest rates and a decline in home values...There is concern that not all banks fully recognize the embedded risks in some of their portfolios.

We have recently seen signs that [underwriting] standards may be under some downward pressure as a result of strong competition and tight spreads.

In the end, we cannot eliminate the risk inherent in mortgages with refinancing options. But we can markedly contain the accompanying risks to systemic stability by diversifying the concentration of risk away from large, highly leveraged portfolios for which misjudgments can have quick and devastating consequences. A system of diversified and less-leveraged interest-rate-risk management would be far more resilient to the inevitable mistakes and shocks of individual risk-mitigating strategies.